YELLEN: Putting off rate hikes could force the Fed to overreact later

Federal Reserve chair Janet Yellen made clear in a speech on
Wednesday that the Fed's December meeting looks likely to see a
rate hike for the first time in nine years.

Yellen said that the labor market has clearly improved, yet
cautioned against declaring that we've hit "full employment,"
which is seen as the point at which all of the "slack" in the
labor market keeping down wages has been taken up.

But with respect to the Fed's upcoming policy decision on
December 16 — at which many market participants think the Fed
will raise rates for the first time since July 2006 — Yellen made
fairly clear, in our view, that it is time for the Fed to abandon
its emergency policy settings.

Here's the key passage:

Were the FOMC to delay the start of policy normalization
for too long, we would likely end up having to tighten policy
relatively abruptly to keep the economy from significantly
overshooting both of our goals. Such an abrupt tightening
would risk disrupting financial markets and perhaps even
inadvertently push the economy into recession. Moreover, holding
the federal funds rate at its current level for too long could
also encourage excessive risk-taking and thus undermine financial
stability.

And so while much of Yellen's commentary, as has been the
case for most of her tenure as Fed chair, cautioned on the Fed's
view of the labor market having reached "full employment" and the
economy growing above trend, it's clear that the Fed is anxious
to begin the process of normalizing rates.

Yellen again emphasized that even after the Fed begins
raising rates it will likely do so in slow steps.

But we're now just two weeks away from the Fed's
highly-anticipated decision, and the message from the Fed's top
official seems pretty clear: rate hikes are coming.

Here's the full text below.

The Economic Outlook and Monetary Policy

Thank you to the Economic Club of Washington for inviting me to
speak to you today. I would like to offer my assessment of the
U.S. economy, nearly six and half years after the beginning of
the current economic expansion, and my view of the economic
outlook. I will describe the progress the economy has made toward
the Federal Open Market Committee's (FOMC) goals of maximum
employment and stable prices and what the current situation and
the outlook imply for how monetary policy is likely to evolve to
best foster the attainment of those objectives.

The Economic Outlook
The U.S. economy has recovered substantially since the Great
Recession. The unemployment rate, which peaked at 10 percent in
October 2009, declined to 5 percent in October of this year. At
that level, the unemployment rate is near the median of FOMC
participants' most recent estimates of its longer-run normal
level.The economy
has created about 13 million jobs since the low point for
employment in early 2010, and total nonfarm payrolls are now
almost 4-1/2 million higher than just prior to the recession.
Most recently, after a couple months of relatively modest payroll
growth, employers added an estimated 271,000 jobs in October.
This increase brought the average monthly gain since June to
about 195,000--close to the monthly pace of around 210,000 in the
first half of the year and still sufficient to be consistent with
continued improvement in the labor market.

Despite these substantial gains, we cannot yet, in my judgment,
declare that the labor market has reached full employment. Let me
describe the basis for that view.

To begin with, I believe that a significant number of individuals
now classified as out of the labor force would find and accept
jobs in an even stronger labor market. To be classified as
unemployed, working-age people must report that they have
actively sought work within the past four weeks. Most of those
not seeking work are appropriately not counted as unemployed.
These include most retirees, teenagers and young adults in
school, and those staying home to care for children and other
dependent family members. Even in a stronger job market, it is
likely that many of these individuals would choose not to work.

But some who are counted as out of the labor force might be
induced to seek work if the likelihood of finding a job rose or
if the expected pay was higher. Examples here include people who
had become too discouraged to search for work when the prospects
for employment were poor and some who retired when their previous
jobs ended. In October, almost 2 million individuals classified
as outside the labor force because they had not searched for work
in the previous four weeks reported that they wanted and were
available for work. This is a considerable number of people, and
some of them undoubtedly would be drawn back into the workforce
as the labor market continued to strengthen. Likewise, some of
those who report they don't want to work now could change their
minds in a stronger job market.

Another margin of labor market slack not reflected in the
unemployment rate consists of individuals who report that they
are working part time but would prefer a full-time job and cannot
find one--those classified as "part time for economic reasons."
The share of such workers jumped from 3 percent of total
employment prior to the Great Recession to around 6-1/2 percent
by 2010. Since then, however, the share of these part time
workers has fallen considerably and now is less than 4 percent of
those employed. While this decline represents considerable
progress, particularly given secular trends that over time may
have increased the prevalence of part-time employment, I think
some room remains for the hours of these workers to increase as
the labor market improves further.

The pace of increases in labor compensation provides another
possible indicator, albeit an imperfect one, of the degree of
labor market slack. Until recently labor compensation had grown
only modestly, at average annual rates of around 2 to 2-1/2
percent. More recently, however, we have seen a welcome pickup in
the growth rate of average hourly earnings for all employees and
of compensation per hour in the business sector. While it is too
soon to conclude whether these more rapid rates of increase will
continue, a sustained pickup would likely signal a diminution of
labor market slack.

Turning to overall economic activity, U.S. economic output--as
measured by inflation-adjusted gross domestic product (GDP), or
real GDP--has increased at a moderate pace, on balance, during
the expansion. Over the first three quarters of this year, real
GDP is currently estimated to have advanced at an annual rate of
2-1/4 percent, close to its average pace over the previous five
years. Many economic forecasters expect growth roughly along
those same lines in the fourth quarter.

Growth this year has been held down by weak net exports, which
have subtracted more than 1/2 percentage point, on average, from
the annual rate of real GDP growth over the past three quarters.
Foreign economic growth has slowed, damping increases in U.S.
exports, and the U.S. dollar has appreciated substantially since
the middle of last year, making our exports more expensive and
imported goods cheaper.

By contrast, total real private domestic final purchases
(PDFP)--which includes household spending, business fixed
investment, and residential investment, and currently represents
about 85 percent of aggregate spending--has increased at an
annual rate of 3 percent this year, significantly faster than
real GDP. Household spending growth has been particularly solid
in 2015, with purchases of new motor vehicles especially strong.
Job growth has bolstered household income, and lower energy
prices have left consumers with more to spend on other goods and
services. These same factors likely have contributed to consumer
confidence that is more upbeat this year than last year.
Increases in home values and stock market prices in recent years,
along with reductions in debt, have pushed up the net worth of
households, which also supports consumer spending. Finally,
interest rates for borrowers remain low, due in part to the
FOMC's accommodative monetary policy, and these low rates appear
to have been especially relevant for consumers considering the
purchase of durable goods.

Other components of PDFP, including residential and business
investment, have also advanced this year. The same factors
supporting consumer spending have supported further gains in the
housing sector. Indeed, gains in real residential investment
spending have been faster so far in 2015 than last year, although
the level of new residential construction still remains fairly
low. And outside of the drilling and mining sector, where lower
oil prices have led to substantial cuts in outlays for new
structures, business investment spending has posted moderate
gains.

On balance, the moderate average pace of real GDP growth so far
this year and over the entire expansion has been sufficient to
help move the labor market closer to the FOMC's goal of maximum
employment. However, less progress has been made on the second
leg of our dual mandate--price stability--as inflation continues
to run below the FOMC's longer-run objective of 2 percent.
Overall consumer price inflation--as measured by the change in
the price index for personal consumption expenditures--was only
1/4 percent over the 12 months ending in October. However, this
number largely reflects the sharp fall in crude oil prices since
the summer of 2014 that, in turn, has pushed down retail prices
for gasoline and other consumer energy products. Because food and
energy prices are volatile, it is often helpful to look at
inflation excluding those two categories--known as core
inflation--which is typically a better indicator of future
overall inflation than recent readings of headline inflation. But
core inflation--which ran at 1-1/4 percent over the 12 months
ending in October--is also well below our 2 percent objective,
partly reflecting the appreciation of the U.S. dollar. The
stronger dollar has pushed down the prices of imported goods,
placing temporary downward pressure on core inflation. The
plunge in crude oil prices may also have had some small indirect
effects in holding down the prices of non-energy items in core
inflation, as producers passed on to their customers some of the
reductions in their energy-related costs. Taking account of these
effects, which may be holding down core inflation by around 1/4
to 1/2 percentage point, it appears that the underlying rate of
inflation in the United States has been running in the vicinity
of 1-1/2 to 1-3/4 percent.

Let me now turn to where I see the economy is likely headed over
the next several years. To summarize, I anticipate continued
economic growth at a moderate pace that will be sufficient to
generate additional increases in employment, further reductions
in the remaining margins of labor market slack, and a rise in
inflation to our 2 percent objective. I expect that the
fundamental factors supporting domestic spending that I have
enumerated today will continue to do so, while the drag from some
of the factors that have been weighing on economic growth should
begin to lessen next year. Although the economic outlook, as
always, is uncertain, I currently see the risks to the outlook
for economic activity and the labor market as very close to
balanced.

Turning to the factors that have been holding down growth, as I
already noted, the higher foreign exchange value of the dollar,
as well as weak growth in some foreign economies, has restrained
the demand for U.S. exports over the past year. In addition,
lower crude oil prices have reduced activity in the domestic oil
sector. I anticipate that the drag on U.S. economic growth from
these factors will diminish in the next couple of years as the
global economy improves and the adjustment to prior declines in
oil prices is completed.

Although developments in foreign economies still pose risks to
U.S. economic growth that we are monitoring, these downside risks
from abroad have lessened since late summer. Among emerging
market economies, recent data support the view that the slowdown
in the Chinese economy, which has received considerable
attention, will likely continue to be modest and gradual. China
has taken actions to stimulate its economy this year and could do
more if necessary. A number of other emerging market economies
have eased monetary and fiscal policy this year, and economic
activity in these economies has improved of late. Accommodative
monetary policy is also supporting economic growth in the
advanced economies. A pickup in demand in many advanced economies
and a stabilization in commodity prices should, in turn, boost
the growth prospects of emerging market economies.

A final positive development for the outlook that I will mention
relates to fiscal policy. This year the effect of federal fiscal
policy on real GDP growth has been roughly neutral, in contrast
to earlier years in which the expiration of stimulus programs and
fiscal policy actions to reduce the federal budget deficit
created significant drags on growth. Also, the budget
situation for many state and local governments has improved as
the economic expansion has increased the revenues of these
governments, allowing them to increase their hiring and spending
after a number of years of cuts in the wake of the Great
Recession. Looking ahead, I anticipate that total real government
purchases of goods and services should have a modest positive
effect on economic growth over the next few years.

Regarding U.S. inflation, I anticipate that the drag from the
large declines in prices for crude oil and imports over the past
year and a half will diminish next year. With less downward
pressure on inflation from these factors and some upward pressure
from a further tightening in U.S. labor and product markets, I
expect inflation to move up to the FOMC's 2 percent objective
over the next few years. Of course, inflation expectations play
an important role in the inflation process, and my forecast of a
return to our 2 percent objective over the medium term relies on
a judgment that longer-term inflation expectations remain
reasonably well anchored. In this regard, recent measures from
the Survey of Professional Forecasters, the Blue Chip Economic
Indicators, and the Survey of Primary Dealers have continued to
be generally stable. The measure of longer-term inflation
expectations from the University of Michigan Surveys of
Consumers, in contrast, has lately edged below its typical range
in recent years. However, this measure often seems to respond
modestly, though temporarily, to large changes in actual
inflation, and the very low readings on headline inflation over
the past year may help explain some of the recent decline in the
Michigan measure. Market-based measures of inflation
compensation have moved up some in recent weeks after declining
to historically low levels earlier in the fall. While the low
level of these measures appears to reflect, at least in part,
changes in risk and liquidity premiums, we will continue to
monitor this development closely. Convincing evidence that
longer-term inflation expectations have moved lower would be a
concern because declines in consumer and business expectations
about inflation could put downward pressure on actual inflation,
making the attainment of our 2 percent inflation goal more
difficult.

Monetary Policy
Let me now turn to the implications of the economic outlook for
monetary policy. Reflecting progress toward the Committee's
objectives, many FOMC participants indicated in September that
they anticipated, in light of their economic forecasts at the
time, that it would be appropriate to raise the target range for
the federal funds rate by the end of this year. Some participants
projected that it would be appropriate to wait until later to
raise the target funds rate range, but all agreed that the timing
of a rate increase would depend on what the incoming data tell us
about the economic outlook and the associated risks to that
outlook.

In the policy statement issued after its October meeting, the
FOMC reaffirmed its judgment that it would be appropriate to
increase the target range for the federal funds rate when we had
seen some further improvement in the labor market and were
reasonably confident that inflation would move back to the
Committee's 2 percent objective over the medium term. That
initial rate increase would reflect the Committee's judgment,
based on a range of indicators, that the economy would continue
to grow at a pace sufficient to generate further labor market
improvement and a return of inflation to 2 percent, even after
the reduction in policy accommodation. As I have already noted, I
currently judge that U.S. economic growth is likely to be
sufficient over the next year or two to result in further
improvement in the labor market. Ongoing gains in the labor
market, coupled with my judgment that longer-term inflation
expectations remain reasonably well anchored, serve to bolster my
confidence in a return of inflation to 2 percent as the
disinflationary effects of declines in energy and import prices
wane.

Committee participants recognize that the future course of the
economy is uncertain, and we take account of both the upside and
downside risks around our projections when judging the
appropriate stance of monetary policy. In particular, recent
monetary policy decisions have reflected our recognition that,
with the federal funds rate near zero, we can respond more
readily to upside surprises to inflation, economic growth, and
employment than to downside shocks. This asymmetry suggests that
it is appropriate to be more cautious in raising our target for
the federal funds rate than would be the case if short-term
nominal interest rates were appreciably above
zero. Reflecting these concerns, we have maintained our
current policy stance even as the labor market has improved
appreciably.

However, we must also take into account the well-documented lags
in the effects of monetary policy. Were the FOMC to delay
the start of policy normalization for too long, we would likely
end up having to tighten policy relatively abruptly to keep the
economy from significantly overshooting both of our goals. Such
an abrupt tightening would risk disrupting financial markets and
perhaps even inadvertently push the economy into recession.
Moreover, holding the federal funds rate at its current level for
too long could also encourage excessive risk-taking and thus
undermine financial stability.

On balance, economic and financial information received since our
October meeting has been consistent with our expectations of
continued improvement in the labor market. And, as I have noted,
continuing improvement in the labor market helps strengthen
confidence that inflation will move back to our 2 percent
objective over the medium term. That said, between today and the
next FOMC meeting, we will receive additional data that bear on
the economic outlook. These data include a range of indicators
regarding the labor market, inflation, and economic activity.
When my colleagues and I meet, we will assess all of the
available data and their implications for the economic outlook in
making our policy decision.

As you know, there has been considerable focus on the first
increase in the federal funds rate after nearly seven years in
which that rate has been at its effective lower bound. We have
tried to be as clear as possible about the considerations that
will affect that decision. Of course, even after the initial
increase in the federal funds rate, monetary policy will remain
accommodative. And it bears emphasizing that what matters for the
economic outlook are the public's expectations concerning the
path of the federal funds rate over time: It is those
expectations that affect financial conditions and thereby
influence spending and investment decisions. In this regard, the
Committee anticipates that even after employment and inflation
are near mandate-consistent levels, economic conditions may, for
some time, warrant keeping the target federal funds rate below
levels the Committee views as normal in the longer run.

This expectation is consistent with an implicit assessment that
the neutral nominal federal funds rate--defined as the
value of the federal funds rate that would be neither
expansionary nor contractionary if the economy were operating
near its potential--is currently low by historical standards and
is likely to rise only gradually over time. One indication that
the neutral funds rate is unusually low is that U.S. economic
growth has been quite modest in recent years despite the very low
level of the federal funds rate and the Federal Reserve's very
large holdings of longer-term securities. Had the neutral rate
been running closer to the levels that are thought to have
prevailed prior to the financial crisis, current monetary policy
settings would have been expected to foster a very rapid economic
expansion, with inflation likely rising significantly above our 2
percent objective.

Empirical support for the judgment that the neutral federal funds
rate is low comes from both academic research and Federal Reserve
staff analysis. Figure 1 employs four
macroeconomic models used by Federal Reserve staff to estimate
the "natural" real rate of interest, a concept closely related to
the neutral rate.The measures of the natural
rate shown in this figure represent the real short-term interest
rate that would prevail in the absence of frictions that slow the
adjustment of wages and prices to changes in the economy; under a
variety of assumptions, this interest rate has been shown to
promote full employment.The shaded blue band represents
the range of the estimates of the natural real rate at each point
in time. This analysis suggests that the natural real rate fell
sharply with the onset of the crisis and has recovered only
partially. These findings are broadly consistent with those
reported in a paper by Thomas Laubach and John Williams, shown in
figure 2.

The marked decline in the neutral federal funds rate after the
crisis may be partially attributable to a range of persistent
economic headwinds that have weighed on aggregate demand. These
headwinds have included tighter underwriting standards and
limited access to credit for some borrowers, deleveraging by many
households to reduce debt burdens, contractionary fiscal policy
at all levels of government, weak growth abroad coupled with a
significant appreciation of the dollar, slower productivity and
labor force growth, and elevated uncertainty about the economic
outlook.As the
restraint from these headwinds further abates, I anticipate that
the neutral federal funds rate will gradually move higher over
time. Indeed, in September, most FOMC participants projected
that, in the long run, the nominal federal funds rate would be
near 3.5 percent, and that the actual federal funds rate would
rise to that level fairly slowly.

Because the value of the neutral federal funds rate is not
directly measureable and must be estimated based on our imperfect
understanding of the economy and the available data, I would
stress that considerable uncertainty attends our estimates of its
current level and even more to its likely path going
forward.That said,
we will learn more from observing economic developments in the
period ahead. It is thereby important to emphasize that the
actual path of monetary policy will depend on how incoming data
affect the evolution of the economic outlook. Stronger growth or
a more rapid increase in inflation than we currently anticipate
would suggest that the neutral federal funds rate is rising more
quickly than expected, making it appropriate to raise the federal
funds rate more quickly as well; conversely, if the economy
disappoints, the federal funds rate would likely rise more
slowly. Given the persistent shortfall in inflation from our 2
percent objective, the Committee will, of course, carefully
monitor actual progress toward our inflation goal as we make
decisions over time on the appropriate path for the federal funds
rate.

In closing, let me again thank the Economic Club of Washington
for this opportunity to speak about the economy and monetary
policy. The economy has come a long way toward the FOMC's
objectives of maximum employment and price stability. When the
Committee begins to normalize the stance of policy, doing so will
be a testament, also, to how far our economy has come in
recovering from the effects of the financial crisis and the Great
Recession. In that sense, it is a day that I expect we all are
looking forward to.